Profit sharing plans, also known as employer discretionary contributions, are commonly confused with a variety of other employer-provided benefits, such as 401k plans. However, they are significantly different!
As a small to mid-sized business seeking to create a reputable workplace for employees, learning the ins and outs of profit sharing plans is beneficial when deciding which benefits are best to offer. This blog is a great place to start.
In the content below, we define profit sharing plans, explore the benefits of starting one, discuss how to set one up, and begin the conversation on whether this option is best for your business.
What Is a Profit Sharing Plan?
A profit sharing plan is an umbrella term for any employer-provided retirement plan that includes discretionary employer contributions and excludes discretionary employee contributions.
As the name implies, profit sharing plans offer a share of company profits to select participants. The business determines how much to contribute to the plan, at select times, often dependent on the success of the company. For example, a business may determine to contribute nothing to the plan during a hard year or two.
However, when profits are being shared, every company must determine a formula for allocation. The comp-to-comp method is the most common method of profit allocation.
The Comp-to-Comp Method of Profit Allocation
The comp-to-comp method requires a bit of math. First, an employer must calculate the total sum of every employee’s compensation. Each employee is entitled to a percentage of the plan, and this is calculated by dividing the individual employee’s compensation with total compensation. Finally, this percentage is multiplied by the total amount being shared.
The IRS determined that contributions for 2021 must be less than 25% of the participant’s compensation or $58,000.
What Are the Benefits for small businesses with Profit Sharing Plans?
First, profit sharing plans benefit your employees. Employer-sponsored retirement plans are one of the most desired benefits a company could offer, and profit sharing plans are tax-advantaged.
Second, profit sharing benefits your company. Providing a retirement savings plan is an excellent way to encourage employee retention, ensuring that highly skilled, highly experienced individuals stay at your company.
Profit sharing in particular provides a sense of ownership – employees are directly benefited when the company succeeds.
One small business resource writes:
Loyalty significantly increases with remuneration. Employees that are offered an opportunity to participate in a profit-sharing plan invest more devotion to their position because of the direct reward associated with it. In addition, it shows the company is invested in the employees as well and creates a sense of parity rather than a composition of titles and ranks; employees envision themselves as transcending associate status and more as owners.
How Can I Set a Profit Sharing Plan Up?
A profit sharing plan is a flexible option, available to businesses of any size. Profit sharing plans can exist in conjunction with existent retirement plans, and a company does not necessarily have to be profitable to establish a profit sharing plan.
Getting started with a profit sharing plan is simple. To apply, a business owner must fill out the IRS Form 5500 and list all participants. Variations of Form 5500 can be selected, depending on the number of plan participants. The employer maintaining the plan must file the form electronically before the due date. During setup, companies must prove that the plan does not favor highly compensated employees. Form 5500 must be filed annually.
We must note that non-profit organizations are the only exception to profit sharing eligibility because non-profits are not structured to be profitable. Even if a for-profit company is not profitable in a certain time period, the company is structured to make a profit and is, therefore, qualified to establish profit sharing.
Profit Sharing Plan vs 401K
What are the differences between a profit sharing plan and a 401k?
- Contributor: In both profit sharing and 401k plans, the employer makes contributions. However, contributions to a personal 401k plan can be made by employees, but contributions to a profit sharing plan are made by the employer only. In this instance, of course, an employer’s contribution to a profit sharing plan does not match the employee’s contribution.
- Contribution Source: In profit sharing plans, the contribution comes from a percentage of the company’s profits. Contributions to a 401k plan can be made by the employee or the employer.
- Contribution Frequency: profit sharing plans place contribution frequency in the hands of the employer. The IRS states: “There is no set amount that the law requires you to contribute. If you can afford to make some amount of contributions to the plan for a particular year, you can do so. Other years, you do not need to make contributions. Also, your business does not need profits to make contributions to a profit-sharing plan.”
Champion Your Small Business Finances with MyRQB
Navigating business finances – from employer-sponsored retirement plans to bookkeeping tasks – is no small job. In fact, we’ve talked to many business owners who simply cannot do it all but cannot afford another full-time employee. Many of these business owners are now our clients!
At Remote Quality Bookkeeping, we are determined to make life easier for business owners with simplified bookkeeping solutions. Our goal is to save your time, allowing you to dedicate your energy to running a business – while we do all the paperwork.
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